Transcript What is Going On in the Current Financial Crisis?

What is Going On? Global
Financial Turmoil
Frank Howland
Wabash College
2 October 2008
Executive Summary
• Modern capitalist economies are prone to
financial crises
• The current crisis was caused by the housing
bubble, excessive leverage, and poor regulation
• The crisis is in essence a series of bank runs,
reflecting a general lack of confidence in the
financial sector
• The “bailout” is designed to improve the capital
position of banks in order to restore confidence
• The crisis will worsen the recession because less
credit means less investment
Outline
• General and Specific Causes of the Crisis
– Important themes in finance: balance sheets,
leverage, asymmetric information
• Chronology
• Policy Options
• The Outlook
General Causes
• Mismatch of financial institutions’ assets and
liabilities on the balance sheet
• Leverage (how much you borrow) increases
fragility of the banking system
• Asymmetric information
Maturity mismatch of financial institutions’
assets and liabilities
Source: Brunnermeier (2008)
Low Leverage
• Suppose I can borrow at 3% and lend at 4%
• I have $1 billion in capital
• If I borrow another $1 billion, I can lend out $2
billion, receive $80 million in interest, pay $30
million in interest and net $50 million per year
(5% return)
• If 5% of the loans default, I suffer $100 million
in default losses. So I lose $50 million (-5%
return)
High Leverage
• Suppose I can borrow at 3% and lend at 4%
• If I borrow $29 billion, I can make $30 billion
in loans.
– Interest expense: 3% x $29 billion = $0.87 billion
– Interest income: 4% x $30 billion = $1.20 billion
– Net revenue = $330 million (33% return)
• If 5% of loans default, I lose on net $1.17
billion (-117% return)
Leverage’s Effects
• Leverage increases expected returns at the
cost of greater risk.
• If the bank you own has negative net worth,
your incentive is to borrow a lot of money.
Heads you win, tails your creditors lose.
• Regulators should recognize this and shut you
down.
Asymmetric Information
• Adverse selection: bad risks are the ones who
accept your offer (what happens before the
transaction). Applies to insurance, but also
loans
• Moral hazard: the risk that the other party will
engage in activities that are undesirable (after
the transaction). Closely related: principalagent problems.
Asymmetric Information
• Banks solve the adverse selection problem by
specializing in figuring out who is a good risk.
• Debt is preferred to stock as a means of
dealing with moral hazard. Short-term debt is
better still, as you can get out quickly.
• Deposit insurance causes moral hazard
problems. Depositors have no need to
monitor bad banks; bad banks have continued
access to funds.
Consequences: Recurring Bank Crises
• United States Bank Panics: 1819, 1837, 1857,
1873, 1884, 1893, 1907, 1930-33
• Mexico, 1994-95
• East Asian Crisis, 1997-98
Source: Mishkin (2003)
Consequences: Recurring Bank Crises
• The Five Big Five Crises: Spain (1977), Norway
(1987), Finland (1991), Sweden (1991,) and
Japan (1992)
• Other Banking and Financial Crises: Australia
(1989), Canada (1983), Denmark (1987), France
(1994), Germany (1977), Greece (1991), Iceland
(1985), and Italy (1990), and New Zealand (1987),
United Kingdom (1974, 1991, 1995), and United
States (1984).
Source: Reinhart and Rogoff (2008)
Specific Causes
• Housing boom and bust
• Securitization
• Recent evolution of investment banking: high
leverage bets on housing
• Poor regulation
• GSE (Fannie Mae, Freddie Mac) involvement
Housing Boom and Bust
Case-Shiller Ten City Home Price Index
250
200
150
100
50
0
Jan-98
Jan-00
Jan-02
Jan-04
Jan-06
Jan-08
Source: http://macromarkets.com/csi_housing/sp_caseshiller.asp
Jan-10
Securitization
• Mortgage Backed Security (MBS): a security
secured by a pool of mortgages.
• Collateralized Debt Obligations (CDOs):
financial instruments in which an institution
creates a new series of assets by repackaging
the cash flows received from a given pool of
underlying assets (some of which might
themselves be CDOs).
Source: http://www.econbrowser.com/archives/2007/06/cdos_whats_the.html
A complicated story
Source:
http://www.econbrowser.com/archives/2008/01/mortgage_securi.html
Source: Shin (2008)
Evolution of Investment Banking
• Continuation of dot‐com bubble
• Same banks made lots of money during
dotcom era hyping and selling over‐inflated
stocks
• End of dot‐com bubble, scarred Main Street
who didn’t want to borrow despite low
interest rates
• I-Banks needed new revenue stream to satisfy
shareholders
Source: Hong, Harrison (2008)
Poor regulation
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SEC allows I-Banks to increase leverage
Credit default swaps are hardly regulated
In general, not enough transparency
Fed does not discourage subprime loans
Who said this?
• “Lenders have taken advantage of credit-scoring
models and other techniques for efficiently extending
credit to a broader spectrum of consumers. . . . [These
models] have reduced the costs of evaluating the
creditworthiness of borrowers, and in competitive
markets, cost reductions tend to be passed through to
borrowers. Where once more-marginal applicants
would simply have been denied credit, lenders are now
able to . . . judge the risk posed by individual applicants
and to price that risk appropriately. These
improvements have led to rapid growth . . . today
subprime mortgages account for roughly 10 percent of
the number of all mortgages outstanding.”
The Liquidity Spiral
Source: Brunnermeier (2008)
Summary Chronology
• Bear Stearns bails out one of its funds in June
2007.
• Since August, 2007 Fed has extended enormous
credit to the banking system in a variety of ways
• Starting in March, 2008 all 5 major investment
banks left the scene
• The federal government has in effect nationalized
a major insurance company (AIG) and most of the
mortgage industry (Fannie Mae, Freddie Mac)
• Major commercial banks have failed
• European governments have rescued several
banks and are proposing bailouts
September, 2008
• Sept 7 Fannie Mae and Freddie Mac put into
conservatorships
• Sept 14 Merrill Lynch sold to Bank of America
• Sept 14 Lehman Brothers files for bankruptcy
• Sept 16 AIG rescued by $85 billion loan from Treasury
in return for de facto federal control
• Sept 16 Reserve Primary money market fund “breaks
the buck”
• Sept 18 Paulson proposes vast bailout
• Sept 21 Goldman Sachs and Morgan Stanley announce
plans to become bank holding companies
Most Recent Chronology
• Sept 25 Washington Mutual seized by FDIC;
assets sold to JP Morgan Chase
• Sept 28 Congress votes down Troubled Asset
Relief Program (TARP); stock market falls 9%
• Sept 28 Benelux nationalize Fortis; Brits seize
mortgage lender Bradford & Bingley; German
banks rescue mortgage lender Hypo
• Sept 29 Wachovia sold to Citi Bank
Current conditions
• Banks refuse to lend to one another and are only
borrowing from central banks
• Banks are having great difficulty selling CDOs.
There is no market for these securities.
• Bond markets: New debt issuance was $15.5
billion in September of this year compared with
$101 billion in September of 2007.
• Total commercial paper outstanding is down $for
both financial and non-financial firms.
• State and local governments are having difficulty
borrowing.
Provisions of Bailout
• Up to $700 billion in financing for purchases of
distressed securities
• Financial Stability Oversight Board gives Congress and
its experts an advisory role
• FDIC increases its insurance of bank deposits to first
$250,000 of deposits
• FDIC can borrow unlimited amounts from Fed
• Affirm SEC’s ability to suspend “mark-to-market”
accounting
• Insurance scheme
• All sorts of nonsense
The Fine Print
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Apart from the Troubled Assets Relief Program, the bill before the Senate includes:
Extensions of the AMT patch, tax deductions on state and local sales taxes, tuition, teacher expenses and real property taxes and tax credits for
business research and new market investors
Energy tax credits and incentives to encourage wind and refined coal production, new biomass facilities, wave and tide electricity generators, solar
energy property improvements, CO2 capturing, plug-in electric drive vehicles, idling reduction units on truck engines, cellulosic biofuels ethanol
production, energy efficient houses, offices, dishwashers, clothes washers and refrigerators, and fringe benefits for employees commuting by bicycle.
A requirement for private insurance plans to offer mental health benefits on par with medical-surgical benefits
Tax relief provisions for victims of this summer's Midwestern floods, and Hurricane Ike
Freezing of deductions for sale and exchange of oil and natural gas, mandatory basis reporting by brokers for transactions involving publicly traded
securities and an extension of the oil spill tax
But it also extends the following tax provisions:
Economic development credit to American Samoan businesses
$10,000 tax credit for training of mine rescue team members
50% immediate expensing for extra underground mine safety equipment
Tax credit for businesses with employees from an Indian reservation
Accelerated depreciation for property used mostly on an Indian reservation
50% tax credit for some expenditures on maintaining railroad tracks
7-year recovery period for motorsports racetrack property
Expensing of cleaning up "brownfield" contaminated sites
Enhanced deductions for businesses donating computers and books to schools, and for food donations
Deduction for income from domestic production in Puerto Rico
Tax credit for employees in Hurricane Katrina disaster area
Tax incentives for investments in poor neighborhoods in D.C.
Increased rehabilitation credit for buildings in Gulf area
Reduction of import duties on some imported wool fabrics, transfers other duties to Wool Trust Fund to promote competitiveness of American wool
Special expensing rules for film and TV productions
And there's more:
Increasing cover of rum excise tax revenues to Puerto Rico and the Virgin Islands
Making it easier for film and TV companies to use deduction for domestic production
Exempting children's wooden arrows from excise tax
Income averaging for Exxon Valdez litigants for tax purposes
Source: http://online.wsj.com/article/SB122286874792094117.html
Arguments for a bailout
• We are in danger of full-scale bank run and
possibly a liquidity trap in which the Fed
cannot prevent prolonged deflation.
• Thus confidence must be restored.
• Government can purchase assets at their
actual value, which is above current market
value. This increases bank capital and
confidence.
Arguments against this bailout
• To be effective, the Treasury must overpay for
the assets it purchases.
• The bailout will support both good and bad
banks, but bad banks must be shut down
before they do further damage.
• A better solution would be to buy part of the
banks, thereby giving them badly needed
capital. Private sector would handle the
“troubled assets.”
Economists’ Views
• Most agree confidence must be restored via
government action.
• Disagreement over role of liquidity vs. lack of
capital (insolvency).
• Disagreement over the appropriate remedy.
• Many see need for Swedish style
nationalization of the banks.
Consequences of the Crisis
• Likely hit to economic growth via deleveraging. A
sharper recession due to tighter credit, greater
uncertainty, lower wealth.
• Bailout may cause interest rates to rise, dollar to
drop.
• Unlikely but worrisome: Great Depression type
reduction in credit to real economy
• Creative destruction: financial sector declines,
goods-producing export sector grows.
Implications for personal finance
• Long term savings picture unchanged: for
most people the best vehicle is still broadly
diversified, domestic and international, stock
funds combined with bond and inflationprotected bond mutual funds.
• Human capital: develop flexible skills.
References
• Brunnermeier, Markus (2008). “Thoughts on a New
Financial Architecture,” Slides from Princeton Forum
Sept 23, 2008.
• Hong, Harrison (2008) - How We Got Here and Some
Lessons? Slides from Princeton Forum Sept 23, 2008
• Mishkin, Frederic. Financial Institutions and Markets,
4th Edition, 2003.
• Reinhart, Carmen and Kenneth Rogoff (2008). “Is the
2007 U.S. Sub-Prime Financial Crisis So Different? An
International Historical Comparison”
• Shin, Hyun (2008). - Crisis on Wall Street Slides from
Princeton Forum Sept 23, 2008.